The escalation of the crisis in the Eurozone calls for new measures to reduce yields on Spanish bonds. This column succinctly lays out the options and finds them wanting. It argues that sovereign bond purchases might not be sufficient to reassure investors. A credible solution will also require a coordinated strategy to address Spain’s competitiveness problem.

The Eurozone crisis has confirmed that a monetary union is more resistant to market pressures than a fixed exchange rate regime. This fact explains why policymakers have been able to muddle through the current crisis by producing compromises and gaining time.

It is however evident that the protection given by the euro against market pressures is rapidly wearing off. The Greek crisis is worsening; growing concerns about external imbalances and debt sustainability have fuelled capital flight; and sovereign interest rates are rising in Southern Europe.

ECB clearing mechanisms mean that no speculative attack by private investors could cause the “sudden death” of the Eurozone;

Market pressures, however, could starve it to death – and rather quickly.

Krugman’s solution

To minimize this risk, Paul Krugman has proposed three solutions:

A credible bank rescue for troubled banks,

Sufficiently large official intervention in bond markets to keep yields manageable, and

Inflation in Germany that is high enough to redress intra-EZ competitiveness imbalances without imposing deflation to the south – an approach which is bound to be self-defeating in any case (see Krugman 2012).

The European 28-29 June 2012 summit made some progress. It sketched a common approach for resolving banking crises, made a little progress on defining a credible framework to stop contagion in the sovereign bond markets, but it made no progress towards a higher Eurozone inflation rate target.

There is still a great deal of work to be done.

Stopping sovereign bond market contagion

The most urgent challenge is to find a more credible way of reducing the spreads on the Spanish bonds. The EZ’s current plan is insufficient; allowing the existing rescue funds (EFSF and ESM) to buy bonds on the open market will buy time but will not fix the problem.1 These funds just do not have enough financial firepower to make a long term defence credible (see De Grauwe 2012).

The basic problem is the existence of two equilibriums.

The good equilibrium is where trust is high, so interest rates and low and the current stock of debt is sustainable – a fact that underpins the trust.

The bad equilibrium where trust is low, interest rates are high and the current stock of debt looks unsustainable – thus justifying the lack of trust in governments’ ability to service the debt without restructuring.

With trillions of euros invested in EZ government bonds, even small shifts in the likelihood of the good versus the bad equilibrium can product massive sell-offs.

What is needed is progress towards some form of Eurobond and/or a stronger commitment to help Spain to return to a good “low-rates/solvent” equilibrium.

Proposals: Pros and cons

Several proposals have been developed:

Proposal 1: Convince the ECB to cap spreads of government bonds (see De Grauwe 2012).

The ECB would intervene as a lender of last resort in the sovereign bond markets.

To be credible, this option should require an increase of the EFSF/ESM resources, either directly or by granting it a banking license so it could borrow from the ECB.

Proposal 3: Agree on an adjustment programme with Spain to provide the funding to refinance its debt and cover its deficit.

This option would also require an increase in the ESM resources to ensure that the ESM could help Italy as well if needed.

A number of observations can be made regarding their relative merits.

Proposal 1 presents a very important advantage: its funding is guaranteed given the ECB’s unlimited capacity to purchase bonds in sovereign debt markets. Moreover, its implementation would be fast and easy as the ECB would be fully in charge of the interventions. The ECB’s commitment should have a strong effect on markets and convince many investors to regain trust in Spanish bonds, thereby limiting the volume of the ECB interventions. From this perspective, the potential impact of this proposal on the ECB’s balance sheet could be low.

Proposal 2 follows the same logic as Proposal 1, but replaces the ECB by the ESM as the lender of last resort to address concerns that Proposal 1 would blur the boundaries between the responsibilities of monetary and fiscal policy and threaten the independence of the ECB. The price to pay for that would be an increase in the resources of the ESM.

It is unclear whether the reduction in the funding costs of Spain would reassure investors completely about the future of the euro. Whilst it is likely that a significant part of the current spreads on Spanish bonds is the result of fear in the markets, the adjustment process needed to improve the fundamentals of Spain could get out of control. In these circumstances, it is possible that some (or many) investors decide to take the opportunity of offloading their Spanish bonds as a precautionary measure, thereby shifting the sovereign risk from private investors to the ECB/ESM.

The key shortcomings of Proposal 1 (ECB cap) and Proposal 2 (EFSF/ESM cap) as well as the associated moral hazard risk could be addressed by following Proposal 3 (Spanish structural adjustment programme).

Obviously this would only work provided that the resources can be mobilized for this purpose. In addition, beyond issues of national sovereignty, the negotiation of a program would need to deal with serious policy questions relating to the speed of adjustment, the nature of the austerity measures and structural reforms as well as the policy mix within the Eurozone.

Spain’s macroeconomic vulnerabilities

To understand better the constraints facing Spain, consider the charts.

Sources: IMF WEO April 2012 and Bruegel REER database

The real exchange rate chart shows Spain has lost competitiveness since the adoption of the euro, causing its current account to move in a high deficit.

The current account balance has improved since 2009 thanks to a fall in import growth but the real effective exchange rate remains overvalued.

The debt to GDP ratio chart shows that Spain’s main problem is not its high government debt.

Still, its public finances deteriorated severely in 2009 and the IMF expects that its public debt ratio will exceed the UK’s debt ratio by 2016.

The real growth chart shows worrisome trends for Spain; GDP is projected to fall by almost 2% this year.

This trend could lead Spain into a debt trap – the debt ratio’s numerator rising with automatic stabiliser spending and its denominator falling with recession. The Spanish situation is all the more difficult to handle that its unemployment rate has exploded since 2008. These observations underline the importance of rebalancing the Eurozone priorities from austerity to growth.

The contrast in the charts with Britain is instructive; despite a higher government debt ratio, Spain is paying higher yields.

One possible explanation is that members of a monetary union issue debt in a currency over which they have no control. Financial markets can drive these countries into default (the bad equilibrium may be self-fulfilling) in contrast to nations who have issued debt in a currency that they can produce in unlimited qualities (thus they always have the liquidity to avoid default, De Grauwe 2011).

A complementary – and more conventional – explanation for the UK-versus-Spain yields is that investors are concerned about the consequences of the loss of the exchange rate as an instrument of economic policy for Spain. Whereas the UK has managed to deal with the financial and economic crisis by allowing a large real effective sterling depreciation (19% between 2007 and 2011), Spain did not.

It is reasonable to assume that this development and the difficulty to improve competitiveness through internal devaluation have become a serious source of concern for investors.

A macroeconomic strategy for the Eurozone as a whole

The unaddressed competitiveness issue creates uncertainty about Spain’s ability to pull through without restructuring of some kind. This dampens the chances that Proposals 1 or 2 will work. Competitiveness is also a fundamental problem on its own right – one that must be addressed during the negotiation of an adjustment program.

One may think that there is no alternative but to muddling through the adjustment process and inevitable pain. This is a risky gamble. The results of the election in Greece have given a serious warning about the limits to people’s acceptance of austerity-only.

From this perspective, it would be a good thing if an adjustment program for Spain would be dealt with within the framework of a macroeconomic strategy for the Eurozone as a whole. This objective can best be achieved through a loser monetary policy and a lower value of the euro (see Feldstein 2012). By adopting this approach, the ECB would follow the IMF’s recommendation to support further growth in the short term (see IMF 2012) as well as Krugman’s advice to let inflation rise in the Eurozone in order to allow for larger inflation differentials between surplus countries (especially Germany) and deficit countries (especially Spain).

Summary

The situation and the way forward suggested in this column can be summarised as follows:

An unconditional commitment of the ECB/ESM to stabilise Spanish bond yields appears unrealistic today given the critical importance of ensuring that Spain continues with responsible fiscal policy and structural reforms. Hence, a certain level of conditionality is required in exchange for financial support.

To restore confidence, Spain will need to implement a program that includes credible commitments to rebuild economic growth and lower unemployment. This requires, in particular, addressing Spain’s competitiveness problem with the support of the ECB. Without this, doubts about the success of the program and the future of the euro would resurface quickly.

20 - 21 August 2018 / Goethe University Frankfurt / Central Bank Research Association (CEBRA) and the Research Center SAFE (Sustainable Architecture for Finance in Europe) at Goethe University Frankfurt